Should the Hong Kong Dollar Be Delinked?

This issue is more than just economics.  Most people recognize that delinking is politically impossible right now.  Both China and Hong Kong are eager to maintain stability in Hong Kong to convince the world that one country, two systems,  works.  There is no way delinking of the Hong Kong dollar will be allowed in the short run, even if economists say it is better to let it float.

Is there a valid economic reason to delink the Hong Kong dollar?  The answer is a qualified no.  If the government of Hong Kong adheres to the linked exchange rate system strictly, there is no convincing reason to delink the Hong Kong dollar.  This has been argued by many people in and outside of Hong Kong.  I will not try to repeat the argument here, except to point out that whatever the pros and cons of floating the Hong Kong dollar are, the debate is irrelevant unless the government has a clear idea about the goal of its macro economic policy other than maintaining the stability of the exchange rate.

The qualification for "no" to delink the Hong Kong dollar is that the Hong Kong Monetary Authority (HKMA) stops meddling with the linked exchange rate system that we have committed ourselves to since October of 1983.  In a pure currency board system, of which the linked exchange rate system of Hong Kong is an example, HKMA has no role to play, and arbitrage by private banks makes sure that the Hong Kong dollar exchange rate does not deviate significantly from the official 7.8 rate to the U.S. dollar.  For example, in a speculative attack, speculators sell Hong Kong dollars and buy U.S. dollars, and drive the market exchange rate above 7.8.  Any such slight deviation, however, will give private banks incentive to arbitrage: they buy Hong Kong dollars from the market at 7.81, say, and sell it to the Exchange Fund at 7.8 for a profit.  This arbitrage process decreases the supply of the Hong Kong dollar and brings back the market exchange rate in line with the peg.

However, the arbitrage process of the currency board system was not allowed to perform perfectly during the stock market "crashes" in the last couple of weeks.  Instead of allowing banks to make profits and bring the market rate back to the peg, HKMA stepped in and increased the interbank overnight lending rates.  This intervention did two things: it shored up demand for the Hong Kong dollar (because interest rate in the Hong Kong dollar is high), and it prevented arbitrage by banks (because arbitrage is a cash-based operation).  One immediate result of this intervention is tumble in the stock market because higher interest rate hurts business prospects, especially in the property market.  Of course the stock market will suffer even without the intervention, because investors bet on a devaluation of the Hong Kong dollar.  But the reason for the intervention is not sound, and it is probably counter-productive.

First, the intervention suggests to speculators that the current currency board system is not working perfectly.  And they are right: the Hong Kong dollar has been persistently on the strong side of the peg since 1990.  This could not have happened if the arbitrage process were allowed to perform perfectly.  Argentina also has a currency board system, but the market rate for its currency has never been very different from the peg as in Hong Kong.  Speculators don't need any more reason to attack the Hong Kong dollar than that the system is not working perfectly.

Second, the intervention suggests that Monetary Authority of Hong Kong is concerned with the peg and foreign reserves.  In a currency board system such as Hong Kong's linked exchange rate system, local currency is completely backed up by foreign reserves (called Exchange fund in Hong Kong).  Changes in foreign reserve are entirely determined by balance of payment of international trade.  If the local economy runs a surplus (or has persistent capital inflow), it will accumulate foreign reserves, which is what has happened to Hong Kong, a city among China, Japan, and Taiwan with one of largest foreign reserves.  These reserves are in the hands of HKMA, which makes seigniorage profits by investing them in safe and low return foreign assets such as U.S. treasury bills.  But do the seigniorage profits belong to HKMA, or the Hong Kong government?  No.  In a pure currency board system, there should be no incentives for HKMA to "manage'' the reserves.  When Hong Kong runs trade deficit, the reserves will deplete.  It is precisely the incentives to manage the reserves that give speculators the impression that HKMA is concerned with the peg.  The reason is simple.  When speculators attack by selling Hong Kong dollars and buying U.S. dollars, in the absence of interventions such as increasing bank rates, arbitrage by the banks will force HKMA to sell its reserves of U.S. dollars to speculators at the peg.  Now, if HKMA is planning to devalue the Hong Kong dollar, any sale of U.S. dollars at the peg rate of 7.8 is a waste of foreign reserves.  HKMA would be better off changing the peg sooner rather than later to save reserves.  Of course, this is exactly what happened to Southeast Asian countries that devalued their currencies.  But these currencies are not backed by foreign reserves as the Hong Kong dollar.  For HKMA to use intervention to fight speculative attacks is to ignore the advantage of the linked exchange rate system of Hong Kong and put Hong Kong in the same boat as in other intrinsically less stable Southeast Asian countries.

Third, in light of the intervention used by HKMA, all the talk about how much foreign reserves Hong Kong has can be counter-productive in stopping speculation.  It is the concern of how much reserves Hong Kong has that invites speculation.  For if HKMA is not concerned, why didn't it allow the banks to make arbitrage profits and maintain the peg?  If for some ulterior motive, HKMA must not allow this to happen, then it would better off cutting short of the boasting of massive Exchange Fund (and massive government Land Fund, which is also mostly in safe foreign assets).  Otherwise, it won't be long for people to realize that HKMA is indeed contemplating whether the level of the peg is too high.

Since its formal establishment in 1993, the HKMA has stated that the principal goal is to maintain the stability of the Hong Kong dollar.  This goal is best served by strictly adhering to the linked exchange rate system.  The HKMA should take steps to roll back recent banking regulations that make arbitrage by private banks more difficult, such as the 1994 modification in the note issuance and withdrawal system that effectively excludes all but the three note-issuing banks from engaging arbitrage.  The HKMA needs to renew and to strengthen its commitment to the open and automatic management of the Exchange Fund.  Otherwise, it would be better for everyone in Hong Kong to let the Hong Kong dollar float, because an imperfect monetary system will be a constant target of speculative attacks.